Question

BEGINNING OF TERM END OF TERM a. Stock market index information: S&P 500 (stock) index level Nasdaq Composite (stock) index level: b. Interest rate information: Prime rate: Federal funds rate: Commercial paper rate (90 days): Certificate of deposit rate (3-month) Treasury bill rate (13 weeks): Treasury bill rate (26 weeks): c. Bond yield information: Treasury long-term bond yield: DJ Corporate bond yield: Corporate (Master) bond yield: High-yield corporate bond yield: Tax-exempt (7-12-year) bond yield: d. Use stock exchange quotations to record the stock price and dividend of one stock from each

Answer 1

Several factors shape the treasury yield curve—monetary policy, inflation expectations, investor preferences, and macroeconomic influences from around the world.

The treasury yield curve describes how treasury interest rates differ across the maturity of treasury assets. The yield curve is determined to a large extent by monetary policy, investors’ expectations of future economic activity and inflation, and investor preferences. While shifts at the short end of the yield curve reflect immediate monetary policy, changes at the long end of the curve reflect the influence of various economic factors that are not limited to the United States alone.

How does a treasury’s maturity help determine its yield?

The shortest-term treasury bills1 are mainly determined by monetary policy. The Federal Open Market Committee (FOMC) sets a target for the federal funds rate (the overnight rate at which banks trade funds parked with the Federal Reserve). The federal funds rate is then the main point of reference for various short-term interest rates including the rate on short-term treasury bills.

Long-term rates differ from short-term rates because of three main reasons:

1. Inflation expectations: Investors’ expectations of future inflation are worked into the yield on long-term treasuries. The relationship between current short-term rates, future expected short-term rates (based on investors’ inflation expectations), and long-term rates is explained by the expectation theory of the term structure. The theory states that the shape of the treasury yield curve is determined by investors’ expectations of future short-term interest rates. Furthermore, the expectation hypothesis implies that holding a one-year bond and rolling the investment over into a new one-year bond each year for 10 years would result in the same wealth as investing in a 10-year bond. In other words, short-term bonds that add up to the same maturity as a single long-term bond are collectively a perfect substitute for the long-term bond. In mathematical form the return on a long-term bond can be expressed as:

This formula shows that the return on a long-term bond is the geometric mean of the expected return on several short-term bonds that add up to the same maturity.

Several factors shape the treasury yield curve-monetary policy, inflation expectations, investor preferences, and macroeconomic influences from around the world. The treasury yield curve describes how treasury interest rates differ across the maturity of treasury assets. The yield curve is determined to a large extent by monetary policy, investors' expectations of future economic activity and inflation, and investor preferences. While shifts at the short end of the yield curve reflect immediate monetary policy, changes at the long end of the curve reflect the influence of various economic factors that are not limited to the United States alone. How does a treasury's maturity help determine its yield? The shortest - term treasury bills1 are mainly determined by monetary policy. The Federal Open Market Committee (FOMC) sets a target for the federal funds rate (the overnight rate at which banks trade funds parked with the Federal Reserve). The federal funds rate is then the main point of reference for various short - term interest rates including the rate on short - term treasury bills. Long - term rates differ from short - term rates because of three main reasons: 1. Inflation expectations: Investors' expectations of future inflation are worked into the yield on long - term treasuries. The relationship between current short - term rates, future expected short - term rates (based on investors' inflation expectations), and long - term rates is explained by the expectation theory of the term structure. The theory states that the shape of the treasury yield curve is determined by investors' expectations of future short - term interest rates. Furthermore, the expectation hypothesis implies that holding a one - year bond and rolling the investment over into a new one - year bond each year for 10 years would result in the same wealth as investing in a 10 - year bond. In other words, short - term bonds that add up to the same maturity as a single long - term bond are collectively a perfect substitute for the long - term bond. In mathematical form the return on a long - term bond can be expressed as: (1 + i_long term)^n = (1 + i^year 1_short term) (1 + i^year 2_short term) ... (1 + i^year n_short term) This formula shows that the return on a long - term bond is the geometric mean of the expected return on several short - term bonds that add up to the same maturity.

2. Risk premiums (because lending money for a longer period of time is usually riskier than lending money for a shorter period of time): The expectation theory fails to explain the persistence of an upward sloping yield curve in the long run because in that period (consisting of several business cycles), short-term interest rates are just as likely to rise as they are to fall. The more-often-than-not upward slope of the yield curve is due to an additional component of yield on long-term bonds—a risk premium. The risk premium serves as a hedge against possible loss of capital over time and consists of:

• Real risk premium
• Inflation risk premium

3. Investor preferences: Investors in long-term treasuries usually develop a preference for treasuries of a certain period to maturity. In other words, investors have a preferred investment range (preferred period to maturity) and will be willing to invest beyond their preferred range only if they are offered a term premium that accounts for risk and serves as an incentive.

How has the treasury yield curve moved and what’s shaping the curve today?

Yields across all maturity periods are currently near historic lows—even after the Federal Reserve hiked the target range for the federal funds rate by 0.25 percent in December 2015. Figure 1 shows the treasury yield curve as of January 27, 2016.

After the Federal Reserve hiked the funds rate, the short end of the curve began to rise as the yield on short-term treasury bills reflected tighter monetary policy (figure 2). The long end of the yield curve did not rise since changes to the federal funds rate do not have a direct impact on long-term yields. As mentioned earlier, long-term yields are influenced by inflation expectations, risk premium, and investor preferences. In fact, the long end of the yield curve has fallen substantially in the past five years (see figure 3).

While immediate monetary policy is responsible for the liftoff at the short end of the curve, several other factors have resulted in the fall at the long end of the treasury yield curve, including:

• Expectations of low inflation
• The Greek crisis, and the slowdown in China and in emerging markets, which have resulted in the flight of capital to safe havens such as long-term US treasuries
• The Fed’s quantitative easing program, which resulted in the removal of more than $1 trillion long-term treasuries from the market between 2010 and 2014

Future changes in the slope of the treasury yield curve are expected to be determined by the course of monetary policy, changes in inflation expectations, and further developments in the global economy.